How to tell if your investments are too risky

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After you make the decision to invest, you must then decide how much risk you can take. The further you step out on the risk spectrum, the better you expect your returns to be. But that better return can be a desert mirage if you don't understand the behavioral aspects of that decision.

More risk will likely mean additional volatility. Volatility is a nice word for describing the wild swings in value that could lead to fear and loss of sleep as the investments work toward the long-term goal of better returns.

There are two components of risk that all investors should understand before investing. The first is the commonly asked, "What is your risk tolerance?" Regulators typically require this question to be asked on account applications and prospect interviews. The second component of risk is not discussed as often, but it is just as important as the first: risk capacity. Both components make up the delicate balance you will need to address in order to reach your goals.

Risk tolerance

This is the measure of whether an investor can emotionally handle fluctuations in value. There is no reason to put yourself through the ringer of investing in an aggressive holding if you head for the exits at the first downturn. Even though addressing risk tolerance is a compliance requirement, there seems to be a disconnect with the average investor.

According to the research firm Dalbar, the average equity investor is dismal at investing primarily due to selling their investments at the wrong time after they have declined in value. According to their 2014 release, the S&P 500 earned a 9.22 percent annualized return, while the average stock investor earned 5.02 percent over the same 20-year period ending in December 2013. The emotional roller coaster of investing causes some investors to buy high, sell low and self-destruct their long-term potential and success.

Risk tolerance solution

Be honest in your assessment of how much risk you can emotionally handle. Don't let the desire for a better return lead you to take on more risk than you can cope with. A helpful exercise would be to remember how you felt in 2008 or in recent market pullbacks like 2011, 2015 or the first few months of 2016.

If you were struggling to sleep or found yourself nervous and questioning the future, you have a portfolio that is too aggressive and does not match your risk tolerance. But if you get excited during market downturns and actually invest more, you likely have a high risk tolerance. Risk tolerance should be one of many components that goes into your investing framework including your age, income level and ultimate financial goals.

Risk capacity

This is completely independent and sometimes in direct contrast with risk tolerance. Risk capacity is the risk required of the portfolio to make and keep the rate of return that is necessary to reach financial goals. Risk capacity can contrast with risk tolerance when, for example, an older investor with a high risk tolerance jeopardizes his financial future by taking on more risk than is appropriate. Even though the investor can emotionally handle volatility, his age requires less risk so his financial goals don't derail as a result of a market downturn. If you don't have the time horizon to allow your portfolio to recover, you can exceed the risk capacity of the portfolio.

For example, if your portfolio loses 40 percent in a downturn, it would take a return of at least 66.7 percent to make you whole. Assuming an annual return of 8 percent per year, it could take over eight years to recover your losses. A 75-year-old investor may not have that time horizon, and therefore couldn't recover the losses.

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Risk capacity solution

Your investments and diversification needs will evolve over time. While you're young, it may be more appropriate to take risks. But your risk needs to be moderated as you age. There's no reason to take large risks if your financial plan has already put you in a winning position by earning consistent growth.

Understanding these key components of risk can help you reach a Goldilocks portfolio. It's not too risky and not too conservative, but just the right consistency to maximize your returns with the least amount of risk necessary to reach financial independence.